the threat in Trump’s deficit spending

In an opinion piece in the Financial Times a few days ago, Gillian Tett points to and expands on a comment in a Wall Street advisory committee letter to the Treasury Secretary.  Although it may not have implications for financial markets today or tomorrow, it’s still worth keeping in mind, I think.

The comment concerns the changes in the income tax code the administration pushed through Congress in late 2017.  Touted as “reform,” the tax bill is such only because it brings down the top domestic corporate tax rate from 35%, the highest in the world, to about average at 21%.  This reduces the incentive for US-based multinationals (think: drug company “inversions”) to recognize profits abroad.  But special interest tax breaks remained untouched, and tax reductions for the ultra-wealthy were tossed in for good measure.  Because of this, the legislation results in a substantial reduction in tax money coming in to Uncle Sam.

Ms. Tett underlines the worry that there are no obvious buyers for the trillions of dollars in Treasury bonds that the government will have to issue over the coming years to cover the deficit the tax bill has created.

 

A generation ago Japan was an avid buyer of US government debt, but its economy has been dormant for a quarter-century.  Over the past twenty years, China has taken up the baton, as it placed the fruits of its trade surplus in US Treasuries.  But Washington is aggressively seeking to reduce the trade deficit with China; the Chinese economy, too, is starting to plateau; and Beijing, whatever its reasons, has already been trimming its Treasury holdings for some time.

Who’s left to absorb the extra supply that’s on the way?   …US individuals and companies.

 

The obvious question is whether domestic buyers have a large enough appetite to soak up the increasing issue of Treasuries.  No one really knows.

Three additional observations (by me):

–the standard (and absolutely correct, in my view) analysis of deficit spending is that it isn’t free.  It is, in effect, a bill that’s passed along to be paid by future generations of Americans–diminishing the quality of life of Millennials while enhancing that of the top 0.1% of Boomers

–historically, domestic holders have been much more sensitive than foreign holders to creditworthiness-threatening developments from Washington like the Trump tax bill, and

–while foreign displeasure might be expressed mostly in currency weakness, and therefore be mostly invisible to dollar-oriented holders, domestic unhappiness would be reflected mostly in an increase in yields.  And that would immediately trigger stock market weakness.  If I’m correct, the decline in domestic financial markets what Washington folly would trigger implies that Washington would be on a much shorter leash than it is now.

 

interest rates: how high?

the speed of interest rate rises

The best indicator of how fast the Fed will raise the Fed Funds rate will likely be the pace of wage gains and new job creation, as shown in the monthly Employment Situation report issued by the Bureau of Labor Statistics.  Infrastructure investment legislation that may be passed by the new Congress next year may also factor into the Fed’s thinking.  On the other hand, the continuing example of Japan, whose quarter-century of no economic growth is due in part to premature tightening of economic policy is also likely to play a part in decision making.

Much of that will be hard to be certain about in advance.  Current Wall Street thinking, for what it’s worth, is that the pace will be north of glacial but not fast at all–maybe a move of +0.50% next year, after a boost of +0.25% later this month.

The endpoint of policy, however, may be somewhat easier to forecast.

the final policy goal

 

Fed policy is aimed at holding inflation at +2.0% per year.  Its main problem recently is that it can’t get inflation that high, in spite of having flooded the economy with money for the past eight years.  So let’s say we’ll have inflation at 2%, but not higher, some time in the future.

cash

If so, and if the return on cash-like investments during normal times continues to provide protection against inflation and little else, then the final target for the Fed Funds rate is 2%.

bonds

If we consider the 30-year bond and say that the normal annual return should be inflation protection + 2% per year, then the target yield for it would be 4%–vs slightly over 3% today.

The 10-year?  subtract 50 basis points from the 30-year annual yield.  That would mean 3.5% as the target yield.

If this is correct, the important thing about the domestic bond market since the US election is the substantial steepening of the yield curve.  While cash has another 150 bp to rise to get to 2%, the long bond is within 100bp of where I think it will eventually settle in.

In other words, a substantial amount of readjustment has already occurred.

 

 

 

 

 

 

what are bond vigilantes? …are they making a comeback?

vigilantes…

Vigilantes were members of 19th century American “vigilance committees,” composed of citizens who banded together to render immediate, and often rough, justice in circumstances where they felt formal law enforcement actions were insufficient.  Whether this was a good thing or not, I don’t know.  But the idea of vigilantes has become part of American folklore.

…and bond vigilantes

I first saw the term “bond vigilantes” in the 1980s in the work of brokerage house economist Ed Yardeni.  My impression is that he invented it   …but, hey, I’m a stock guy not a bond expert.  The idea was that should the Fed falter, due to political pressure, in its mandate to contain inflation under Paul Volcker (as it had throughout the 1970s, under his predecessors), private bond investors would step into the Treasury market and tighten money policy (by pushing up bond yields) whether the Fed liked it or not.

The concept later morphed into the idea that private bond investors would routinely raise and lower bond prices, and thereby interest rates, in the way sound money policy would dictate.  The market would act in advance of formal Fed moves.  Fed actions wouldn’t normally break new ground, but would serve to validate the direction the market was already taking.  This supposedly took some political heat away from the Fed during the long and difficult road of containing the runaway inflation of the Seventies.

Like most generalizations from current experience, the bond vigilante idea worked for a while.  But it has long since lost its usefulness.  For one thing, China became a huge factor in the US bond market as it recycled its trade surpluses.  And Alan Greenspan gradually developed a penchant for smoothing every little bump in the economic road with another huge dollop of easy money.  Ironically, one of the “problems” he dealt with in this manner was the Y2K scare–popularized almost single-handedly by the same Ed Yardeni.

(If you recall, the thesis was that, due to a programming shortcut, every electronic device that contained a computer chip with a clock in it would stop working at the stroke of midnight on 12/12/1999.  That meant refrigerators, elevators, ATMs, PCs…everything.  Software of all types would go kablooey, as well.  So bank and medical records would likely disappear.  During 1999, survivalists were in their glory.  They stockpiled horse-drawn plows–inconveniencing the Amish considerably–and gold and silver coins.  Regular people stockpiled water and gasoline (because pumps might not work, either.

It’s hard to know–since none of the bad stuff happened–whether Yardeni was a hero for alerting the world in time to avert the worst, or just a little nuts.  But he certainly gave Greenspan an excuse for maintaining an easy money policy.)

why the trip down memory lane?

I think I saw the activity of bond vigilantes in trading during the first quarter of this year.  The 30-year yield moved up from 2.94% in December 2011 to 3.33% last week.  The 10-year yield went from 1.94% to 2.21% over the same span.  This, despite Ben Bernanke’s continual assertion that the Fed intends to keep interest rates low through this year and next.

Of course, yields have reversed themselves sharply in the current mini-panic over the latest Employment Situation report and the uptick in southern EU bond yields.  But I read this more as a ripple caused by short-term traders than anything else.

And why shouldn’t the bond vigilantes re-appear?  After all, Mr. Greenspan no longer has his hand on the money spigot.  And China is much less of a net buying force in Treasuries than in the past.

Significance?  We may be seeing the first steps in the normalization of interest rates–far in advance of when the Fed wishes.  Two implications, assuming the markets are correct:

–the US economy is in better shape than the consensus realizes, and

–a sharp divergence in performance between stocks and bonds–in favor of the former (previously, I’d made a typo here)–may be about to begin.